Many entrepreneurs shy away from accounting as it may seem like a long and tedious process that takes time away from operating the business, and you're not wrong. However, as an entrepreneur, you’ll be interacting with these topics where a minimum of accounting knowledge will come in handy. Knowing your numbers and understanding the accounting basics will allow you to understand your business's performance. It will also allow you to impress investors looking for people who know their business by the book and can speak about their numbers well.
Whether the economy is expanding or slowing down, knowing the state of your enterprise’s financials can be a practical skill set for making quick decisions that may allow you to take advantage of the environment.
One of the first things a banker will ask you when applying for a business loan is your working capital and working capital ratios. Working capital is one of the ways to measure a business's short-term liquidity and if your business can pay its current liabilities. Here is the formula with an example.
Working capital = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
($354,000 = $537,000 − $183,000)
Current assets can include but are not excluded to cash & cash equivalents, accounts receivable, inventory, prepaid expenses, and all other assets that can be realized over the next 12 months. Current liabilities include but are not excluded to accounts payable, current portion of long-term debt, deferred revenue, and all other liabilities that may come due over the next 12 months.
Alternatively, you can calculate your working capital ratio with these values by dividing current assets by current liabilities. The utilization of that ratio is very similar to the Working Capital calculation. Current assets are the assets that you have access to in the short term (can liquidate within one year) to pay for your current liabilities. Your current liabilities are liabilities that will come due within a year.
A company can pay its short-term liabilities and bills as they come due if they have positive working capital. Depending on your industry, you may need higher or lower working capital.Low working capital can work if cash is coming in quickly and continuously.
EBITDA is Earnings Before Interest, Taxes, Depreciation, and Amortization. EBITDA is a good way to calculate the cash flows created from a business's ongoing activities & can be used to measure profitability to a certain degree. To calculate EBITDA, calculate the following.
EBITDA = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑇𝑎𝑥𝑒𝑠 + 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 + 𝐴𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛
All these figures should be on your income statement. A company that will succeed over the longterm has a positive EBITDA. We will see how they take EBITDA further in the Debt ServiceCoverage Ratio.
*Depreciation & Amortization will be hidden within the cost of goods sold or operating expenses depending on certain factors. To find specific D&A, look at your cash flow statements.
If you're wondering whether your business can take on more debt, the debt services coverage ratio (DSCR) is an excellent indicator. When you're at the bank asking for a loan, you'll likely need to know your DSCR. It's an indicator of your ability to make debt-related payments on time. We can calculate it by dividing your EBITDA by all principal and interest payments within the same timeline as your EBITDA figure. So, for example, if your EBITDA figure is for the last twelve months (LTM), you take all principal & interest payments from the last twelve months.
Let’s analyze the formula and follow up with an example.
$53,000/ ($7,000+$11,000) = 2.9 Debt Services Coverage Ratio
A 2.9 Debt Services Coverage ratio indicates that for every $2.9 you have, you are spending $1on debt service payments. The general rule for a good Debt Services Coverage Ratio is 2.0 or higher. Given our ratio calculated above, we can take on additional debt.
Another question you may be asked at a banking or investment meeting is your debt-to-equity ratio. Your debt-to-equity ratio is the amount of debt you carry compared to the amount the shareholders have invested into the business. In the context of the debt-to-equity ratio, equity refers to the book value of the shareholders' equity (what shows up on the statement of financial position). Regarding equity, we are talking about the book value, shareholders' equity, which appears on the balance or statement of financial position. You will use this ratio to assess how leveraged your company is.
Below we'll cover an example with the formula.
1.5 = $125 000 / $75 000
As with the other terms, bankers and investors use the debt-to-equity ratio to determine the viability of loaning to your business.
This section will dive into two closely related terms, Gross Profit Margin and Net Profit Margin.
Gross profit is revenue minus the cost of goods sold (COGS). The Gross Profit margin is Gross profit divided by revenue. This measure indicates to investors and accounting personnel how well a company produces revenue relative to the cost of producing those goods.
The net profit is Revenue - Total Expenses (COGS + Operating expenses + Other expenses, including taxes & interest expenses). Consequently, the net profit margin is net profit divided by revenue. This indicator is widely used in finance and banking to figure out if a company has been and will be successful in the future. The higher your net profit margin, the more investors will be interested, and the safer you'll be considered by banks & investors.
Inventory turnover refers to the speed at which inventory enters your business and is sold to customers. This formula is valuable to business owners looking to see the time between receiving and selling inventory. A closer look at these data points can help determine the efficiency of your operations.
Let’s look at the formula and follow up with an example.
To calculate it, you'll want to find the cost of goods sold for your business within a certain period, say, fiscal year 2021. As for the average value of inventory, take ((Beginning Inventory +Ending Inventory)/2). For an explanation, we’ll be looking at Apple’s Inventory Turnover.
(*All data in millions, *Apple has a fiscal year end of September 25th, 2021)
36.1 = 192,266 / ((4,061+6,580)/2)
What this 36.1 means is that apple's inventory will fully turnover 36 times per year. The higher the number, the more efficient your business is at turning over inventory and selling it. What's your inventory turnover?
Suppose this article has created a few more questions you might have regarding operating & understanding your business. In that case, you might be interested in checking out our series of articles on the common struggles of operating an SMB and how to overcome them. We've also got an accounting & finance glossary on our website that may answer questions about other terms you're unsure about.
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